The Craze That's Sweeping The Continent: Mergers
Amid improving economic growth and a wave of corporate restructurings, mergers, and acquisitions, investors in European equities didn't have to work too hard to make money in 1997. Despite October's correction, European stock markets returned an average of 30.5% in local currency and 18.5% in U.S. dollars, according to Morgan Stanley Capital International.
Now the big question is whether European bourses have enough juice left for an encore performance. Analysts say gains in the 10% range are more likely. "The first six months of 1998 could be pretty positive," says Richard G. Davidson, European equity strategist for Morgan Stanley, Dean Witter, Discover & Co. in London. But Asian turmoil looms over Europe's bourses, just as it does over every stock market worldwide. With many stocks near all-time highs, a big shock from the Far East could quickly spark a wave of profit-taking.
BUYOUT BAIT. But investors still have reason to like Europe. The economic climate looks favorable: Most countries are starting to show stronger growth, with a Continent-wide average of 2.5% to 3% anticipated. European interest rates are expected to rise only nominally. And stocks should gain support from some other important factors. Billions of dollars are flowing into European leveraged-buyout funds. At the same time, the growth of the private pension industry should bring in new liquidity and create demand for equities.
Moreover, merger fever is being whipped up by the expected launch of a single currency on Jan. 1, 1999. And as companies jockey for position in the Continent's new Euro Zone, they are taking steps to attract investors by enhancing shareholder value. Many corporations are disposing of unwanted assets and trying to build pricing power. This should be a plus for share prices. For example, Anglo-Dutch consumer-products giant Unilever PLC is sharpening its focus on consumer products. And British defense producer General Electric Co. is beginning a long-awaited restructuring campaign under its new chief executive, George Simpson.
Merger mania is particularly evident among financial-services companies. Most recently, Union Bank of Switzerland joined forces with Swiss Bank Corp. The merger created the world's second-largest bank, to be known as United Bank of Switzerland. Continued consolidation is predicted in an increasingly crowded market. "Merger activity could become as intense as it was in the U.S. in the 1980s," says Rick Sapp, head of corporate finance at Goldman Sachs International in London.
What might be snapped up? Abbey National in Britain, Banque Nationale de Paris and Paribas in France, and Populare and Argentinia in Spain are among the institutions on the lists of investment bankers. Banks looking to acquire others may include Britain's Barclays and Germany's Deutsche Bank and Dresdner, which have been largely left out of this year's dealmaking. "The pressure is on in Germany," says Terence C. Eccles, a financial merger specialist at J.P. Morgan & Co. in London.
KOHL OUT? With general elections scheduled for fall, Germany may be the wild card for investors. A Social Democrat victory over longtime Chancellor Helmut Kohl could whack the stock market. The Socialists are well ahead in the polls, but many political analysts still think Kohl will find a way to win. Much depends on economic performance. The consensus is for 2.5% to 3% growth for 1998, but a growing number of analysts think that a global slowdown coupled with interest-rate hikes by the Bundesbank may start impinging on the economy by election time. If so, the shares of industrial giants such as Hoechst and Daimler Benz could come under pressure.
Most analysts think that France, whose stocks have largely trailed the rest of Europe over the last year, offers good value. The headlines have focused on the demands of French labor, but mergers are picking up, and some French companies, including food giant Danone, are getting serious about restructuring. The French market is also heavily weighted toward the consumer sector--making it less vulnerable than Germany's to shocks from Asia and elsewhere, says Gary Dugan, European strategist at J.P. Morgan in London. With growth in Europe likely to come in at around 2.5% next year, Dugan likes phone giant Alcatel, auto maker Renault, and drugmaker Rhine-Poulenc.
Investors are also sanguine about Italy, which now looks likely to join the single currency although its public debt remains huge. Prime Minister Romano Prodi is wrestling the budget deficit down. Once Parliament approves his new budget, interest rates may come down, boosting stocks higher. Andrea Azzimondi, Italian equity strategist at Credit Suisse First Boston in London, recommends fast-growing cellular communications operator Telecom Mobile Italia, which still has further room to expand, and energy giant ENI, which is cheap compared to other European oil stocks.
Britain, whose economy was by far the strongest performer among major European countries in 1997, may face slower growth ahead. The Bank of England, which has raised short-term rates 1.25 percentage points, to 7.25%, since last May's election, wants to see growth cut below 2% next year. With growth currently at 3.5%, such a dramatic reduction seems unlikely. Export orders remain remarkably strong despite the strength of the pound.
While there are signs that consumer spending is peaking, there is still a lot of steam, particularly in the London area. This has some analysts figuring that British stocks without Asian exposure are a pretty safe play. Among them: Supermarket chains J.Sainsbury and Tesco, drugmaker Glaxo Wellcome, and utilities including Scottish Power and National Power.
SUNNY SIDE. What could sour the outlook for Europe? Davidson of Morgan Stanley points out that European companies obtain more than 9% of their revenues from Asia and another 4.6% from Latin America, which is vulnerable to Asian contagion. Morgan Stanley has already downgraded its earnings- per-share growth forecast for Europe in 1998 from 12.7% to 10.5% because of the crisis in Asia.
Countries likely to be hit hardest are Sweden and Finland, which are big capital goods exporters. Some big British companies are also vulnerable. They include Cable & Wireless, which is heavily dependent on Hong Kong, as is Standard Chartered and HSBC Holdings. French luxury-goods makers LVMH and Hermes International are both highly dependent on depressed Japan.
In addition to Asian stress, unexpectedly high rate hikes by the Bundesbank or the Federal Reserve could scramble markets. However, many strategists prefer to see the sunny side right now. "We continue to see very significant opportunities in Europe. That is where we see earnings growth," says Henrik Strabo, an international portfolio manager with American Century Investments. The coming year looks good, but if you're among the fainthearted, you may want to sit this one out.